Convertible Notes, the Path to Cheaper Financing in an Uncertain World

Overview

Financing is essential to early-stage entities – given the significant, upfront investment necessary to research, develop and bring new products and services to markets, entities will often turn to complex debt and equity transactions to infuse cash into the business. Convertible note became preferred fundraising instrument for various companies from publicly traded companies to startups because it allows issuers to take advantage of lower interest rates compared to vanilla debt during the high-interest rate environment and uncertainty in economic markets. Increased demand in convertible notes is expected to continue at least through 2025.

What’s a Convertible Note?

Convertible notes, also known as convertible promissory notes or convertible debt, are a type of debt instrument commonly used to secure financing. They represent a loan that can be converted into equity at a later stage, usually during a subsequent financing round or an exit event.

Typical Convertible Note Terms

Interest: The convertible note earns a rate of interest like any other debt investment. The interest is not typically paid in cash, but accrued, which means the value owed to the investor builds up over time.

Maturity Date: Convertible notes carry a maturity date, at which the notes are due and payable to the investors, if they have not already converted to equity. Some convertible notes have an automatic conversion feature at maturity.

Conversion Provisions: The primary purpose of a convertible note is that it will convert into equity at some point in the future. The most common method of conversion occurs when a subsequent equity investment exceeds a certain threshold. This is called qualified financing. At this time, the original principal plus any accrued interest converts into shares of whatever new equity was just sold. If qualified financing does not occur before the maturity date, some convertible notes also include a provision in which the notes automatically convert to existing equity units, at a set valuation, on the maturity date.

Conversion Discount: When the convertible notes convert to equity in the event of a qualified financing, not only do the note holders get credit for both their original principal plus accrued interest to determine how many shares they receive, they also generally get a discount to the price per share of the new equity. For example, if the discount is 20% and the new equity in the qualified financing is sold at $5 per share, the convertible note’s principal plus accrued interest converts at a share price of $4 per share.

Valuation Cap: In addition to the conversion discount, convertible notes also typically have a valuation cap, which is a hard cap on the conversion price for noteholders regardless of the price per share on the next round of equity financing resulting in potential more upside for this investment.

Practical Example

An investor purchases $100,000 of convertible notes that carry a 6% interest rate and a 20% conversion discount. In a qualified financing that occurs two years after the convertible notes are sold, the company sells equity at $4 per share. At this point, the notes will have accrued $12,000 in interest, making the amount owed to the note investor $112,000. With the 20% discount, the conversion price for the notes is $3.20 per share, and the investor receives 35,000 shares of the new stock. Had the investor waited to purchase the stock at the time of the qualified financing, they would have received 25,000 shares of stock, so it is clear there is a big reward to the convertible note investor for taking the risk of investing earlier.

Valuation Considerations

The valuation of convertible debt, which often includes features like conversion options or various embedded derivatives, can be complex. More specifically,

• Valuation models most widely used for the convertible debt would include: a combination of discounted cash flow (DCF) analysis and the Black-Scholes model, binomial lattice and Monte Carlo simulation.
• The inputs to these mathematical models would typically include: the economic terms of the notes, issuer specific metrics such as the value of the underlying asset, borrowing cost/credit spread, expected dividend and volatility.
• In order to correctly value the expected economics of the convertible notes, a scenario analysis is often required to take into consideration the likelihood of different exit events such as next qualified financing or sale/IPO of the company.

It’s often worth considering the accounting treatment when an instrument’s terms and features are being contemplated by deal teams as entities may need to employ complex valuation techniques and models to appropriately measure these elements at initial recognition and subsequent reporting periods.

Accounting Complexities

Convertible Notes include embedded features such as a conversion right, redemption right with characteristics of debt and equity and therefore, one of the main challenges is determining the accounting assessment of the embedded features as financial derivatives. This determination requires a thorough understanding of the terms and conditions of each feature, as well as the application of relevant accounting standards. Improper assessment can lead to significant misstatements in financial statements, impacting key financial metrics and investor perceptions.

In some cases, convertible debt is issued on a stand-alone basis, and it is apparent that there is only one unit of account. In other financing transactions, convertible debt is issued with detachable warrants or other derivatives intended to offset share dilution. If these other instruments are legally detachable and separately exercisable, they must be accounted for separately from the convertible debt in accordance with other applicable accounting standards.

Another challenge involves the modification of a convertible debt instrument which may represent an extinguishment or require an amount to be recognized in equity. It may also change the accounting model that is applied. Settlements are complex because they may be reflected as extinguishments or conversions depending on the circumstances. Some settlements may reflect induced conversions, which require special accounting considerations.

Issuers often enter an accompanying over-the-counter derivative transaction known as “call spread” with banks to offset their obligations under convertible notes. The call spread allows the issuer to lower the conversion price and have certain tax benefits. The call spread is subject to accounting assessment to determine whether it meets the definition of a derivative and is recognized at fair value.

In addition, the subsequent measurement of convertible debt depends on which accounting model applies. For example, if the conversion option must be accounted for as a derivative instrument, the entity must periodically remeasure its fair value, which may require a complex valuation model.